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Retirement Accounts: 401k and IRA

A primer on the two most popular types of retirement accounts in America.

If you're looking for a legal tax shelter that also helps you save for retirement, then look no further than a 401k or IRA. Both retirement accounts give you the option of reducing your taxable income by the amount that you contribute to them while also allowing the investments therein to grow tax-free until you need them in your golden years.

As pensions and other types of defined-benefit plans have declined in popularity over the years, it's become incumbent upon individual Americans to save for their own retirements. The government helps by offering incentives to do so -- namely, tax deductions associated with 401k and IRAs.

For a 401k, a savings plan that's generally established by an employer for his or her employees, you can make an $18,000 contribution in 2015 -- employees aged 50 or older can contribute an additional $6,000. For a traditional IRA, a savings plan established by an individual, the contribution limit this year is $5,500 ($6,500 if you're age 50 or older).

The impact on your taxes can be substantial. Let's assume that you're under the age of 50, single, and earn $100,000 in taxable income. Your federal income tax liability in this case would be $21,071. However, if you're eligible to contribute to an IRA, you can reduce this amount by $1,540 by contributing the maximum $5,500. Alternatively, if you instead max out your 401k, then your tax savings add up to $4,778.

For someone trying to grow their wealth, legal tax shelters like these are incredibly valuable. Had the person in the above example not contributed the maximum amount to his or her 401k, their after-tax income for the year, holding all else equal, would have increased by only $78,929. But by doing so, their after-tax income will instead grow by $83,707. This is why I like to think of the tax savings offered by retirement accounts as an immediate return on the money deposited therein.

It's worth noting, moreover, that there are different types of 401k and IRA plans. In both instances, for instance, there are "Roth" versions of the accounts. These don't give you a tax deduction up front, but what they do give you is a tax break when you withdraw the money. Under traditional 401k and IRA accounts, investment gains therein are taxed after you retire and start withdrawing them. In Roth accounts, all qualified gains are tax-free.

There are also versions of these accounts designed for self-employed persons. With respect to "one-participant" 401k plans, all of the rules that govern their traditional counterparts apply. For "SEP" IRAs, on the other hand, the contribution limits are significantly higher than for a traditional IRA. In 2015, a self-employed person can deposit 25% of their annual income up to a maximum of $53,000.

The point here is that both types of accounts, and their respective variations, give Americans a legal tax shelter that they can use to reduce their tax liabilities this year while simultaneously stashing money aside for retirement.

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